International Tax – Base erosion and profit shifting

The Organization for Economic Cooperation and Development (OECD) issued a 15 point action plan on base erosion and profit shifting (BEPS). The plan aims to “effectively prevent double non-taxation” and to ensure that low tax jurisdictions will not be able to continue with practices that “artificially segregate taxable income from the activities that generate it”.

It seems that the action plan of the OECD will have a huge impact on worldwide transfer pricing and these actions must be carefully considered as it may have a major impact on how multinational groups operate.

Tax Challenges of the Digital Economy The growth of the digital economy has been identified as one of the major issues that have to be addressed, taking into account its impact on BEPS. It is important that an internationally consistent system has to be implemented to identify the profitability of digital activities. The intangible nature of digital activities makes it harder to control while clarity has to be obtained of what generates the value in this industry to determine to what activities the profits can be attributed.

Neutralising the effects of hybrid mismatch arrangements Hybrid mismatch arrangements are used to achieve unintended double non-taxation or the long-term deferral of tax payments. The focus will most possibly be on changes to international conventions, domestic law provisions and treaty provisions to prevent the improper use of the hybrid mismatch arrangements to achieve tax benefits.

Strengthening Controlled Foreign Corporation (CFC) rules CFC rules will be reinforced to prevent abnormal tax deductions of expenses paid by group companies in high tax jurisdictions to other group companies in low tax jurisdictions. The current CFC and anti-deferral rules may not always counter BEPS in a comprehensive manner.

Limiting base erosion caused by interest deductions and other financial payments Excessive interest payments between related companies is another issue of concern as it could result in substantial base erosion. Transfer pricing guidance will be developed regarding the pricing of related party financial transactions, including guarantees, derivatives and captive and other insurance agreements.

Harmful tax practices and transparency and substance The “race to the bottom” nowadays is more in the form of across the board corporate tax rate reductions on particular types of income such as interest and royalties. To counter these harmful tax practices, factors such as transparency and substance need to be taken into account. This will require compulsory spontaneous exchange on rulings related to preferential regimes and requiring substantial activity for any preferential regimes.

Preventing treaty abuse Treaty provisions and domestic rules should prevent the granting of treaty benefits in inappropriate circumstances. Tax treaties are not intended to be used to generate double non-taxation and certain tax policy considerations that countries in general should consider before entering into a tax treaty with another country. Further work is required on revamping flawed tax relations between jurisdictions, and tax treaties (also referred to as treaty-shopping), responsible for many abusive tax policies in particular in the case of double non-taxation.

Artificial avoidance of permanent establishment (PE) status Particular mention is made to the interpretation of treaty rules on agency-PE rules which allow “contracts for the sale of goods belonging to a foreign enterprise to be negotiated and concluded in a country by the sales force of a local subsidiary of that foreign enterprise without the profits from these sales being taxable to the same extent as they would be if the sales were made by a distributor”. It is noted that many multinational groups would rather evade having a permanent establishment, and continue to do so artificially by fragmenting their operations. Changes will thus be made to the PE definition to prevent this artificial avoidance of creating a PE in relation to BEPS.

Transfer pricing alignment with value creation Transfer pricing and the enforcement of the arm’s length price remains a major issue. Recognizing the role of transfer pricing in profit allocation procedures but the removing of risk can deliberately result in the allocation of profit to low-tax jurisdictions. A reliable and aligned Transfer Pricing system across countries is required. The report deals with intangibles, risk and capital, and other high-risk transactions.

With regard to intangibles the goals include a broad and clearly delineated definition of the term, the recognition of intangibles and an adequate assignment of these intangibles to value creation, as well as the development of specific rules for the hard-to-value intangibles.

Regulations that dictate the relationship between assumed risk and capital provision must be improved while rules must be developed to prevent transactions which would normally not be entered into between third parties as these transactions will thus have little or no available comparables.

The circumstances in which transactions can be re-characterized as well as the use of transfer pricing methods in global value chains will be clarified. Regulations will be generated to prevent base erosion through management fees and head office expenses.

Disclosure of aggressive tax planning arrangements This particularly interesting action focuses on firm disclosure by taxpayers. Greater information disclosure on taxpayers requires a consistent system which creates more transparency of a group’s global value chain, giving each country further access to a group’s transactions outside its own jurisdiction.

Re-examining transfer pricing documentation Greater transparency also relates to transfer pricing and the value-chain analysis. This would require significantly more disclosure of a group’s worldwide activity with transfer pricing documentation being re-examined to level the information between taxpayer and authorities.

 More effective dispute mechanisms The dispute process when treaty-related disputes occur under mutual agreement procedure (MAP) must be improved through a mandatory, binding arbitration provision, resulting in changes to the Model Tax Convention and specific tax treaties.

Development of a multilateral instrument An entirely new mechanism for solving international tax issues will be suggested to jurisdictions which wish to take part.

Conclusion The action plan addresses particular circumstances which have resulted in double non-taxation or the abnormally low taxation of corporate profits.

These circumstances may have resulted in major base erosion through profit shifting and may have caused a loss of revenue to governments across the world. It may even, indirectly, contribute to developing countries being unable to deliver on the basic needs of their population while stimulating the financial decline.